Measuring Currency Risk Premium: The Case of Turkey

ABSTRACT This study examines the determinants of a change in currency expectations for the Turkish Lira (TL) versus the US dollar with different maturities (1 month, 3 months and 1 year). The risk premium is estimated using the interest rate differential and a latent component called the missing risk premium . The empirical model is extended to break down the risk component by introducing other explanatory variables, such as currency swap agreements, credit default swap (CDS), foreign reserves and the volatility index (VIX). A state‐space model is employed to explain the behaviour of an unobserved variable over the period between January 2005 and March 2023 with daily and weekly data frequencies. Our findings suggest that the uncovered interest parity (UIP) condition does not hold consistently in Turkey during this period. Deviations from UIP can be attributed to a time‐varying risk premium as outlined in Fama's framework. Additionally, our analysis also shows that interest rates and swaps play a significant role in explaining the variations in the TL's risk premium. Moreover, we found a substantial increase in both the level and volatility of the missing risk premium for longer maturities after 2018. Incorporating observable variables substantially reduces both the magnitude and the long‐lasting impact of the missing risk premium shocks on expectations. Overall, this study sheds light on the intricate relationship between monetary policy changes, exchange rates and risk premia in the context of an emerging market.